M&A Vocabulary – Understanding the experts: “Profit and Loss Agreement”

In corporate practice, so-called profit and loss transfer agreements (Profit and Loss Agreements) are concluded between companies due to significant tax advantages. A profit and loss transfer agreement is a contract between two companies under which a dependent company transfers part or all of its profit to the controlling company, which in return undertakes to compensate any losses. This agreement is often concluded in the context of a tax group (Organschaft). Profit and loss transfer agreements can also be concluded in combination with a so-called control agreement in order to place the dependent company under the unified management of the parent company and thus also be able to issue instructions to the management board of the dependent stock corporation. However, such a group agreement is not necessary to obtain a tax Organschaft. In practice, concluding a group agreement is also avoided insofar as it would otherwise result in employees employed by the subsidiary being attributed at the level of the parent company. The One-Third Participation Act provides for this only if there is a control agreement between the two companies, but not when a profit and loss transfer agreement is concluded.

Contracting Parties

The dependent company may take the form of a stock corporation (AG), partnership limited by shares (KGaA), SE and, under certain conditions, also a GmbH. The controlling company, by contrast, is not tied to any particular legal form.

Content of the agreement

The dependent company undertakes to transfer its entire profit to the controlling company. In return, the contracting party undertakes to compensate any annual net loss for the duration of the agreement. “Entire profit” is understood to mean the net profit for the year (Bilanzgewinn) that would arise if no profit and loss transfer agreement existed. In the final commercial balance sheet, this is no longer shown as profit but as a liability, after having been recorded as profit only in a preliminary balance sheet to determine the amount to be transferred. In the profit and loss statement, the amount to be transferred is shown separately as an expense. If there are outside shareholders/partners in the dependent company, an appropriate cash settlement for the sale of the share to the controlling company and an annual compensation payment must be provided for if the shareholder remains in the company. The compensation should provide for a recurring cash payment based on an average profit to be determined.

Formal requirements for profit and loss transfer agreements

For a profit and loss transfer agreement to be effective, prior approval resolutions are required.

On the side of the dependent company, (in the case of a stock corporation) the general meeting must approve with a three-quarters majority of the share capital represented. This approval resolution must be notarized. If, however, the dependent company is a GmbH, the resolution is passed by the shareholders’ meeting. It is disputed whether the latter can be adopted only with the consent of all shareholders or whether a three-quarters majority is also sufficient. To avoid jeopardizing the agreement, it is advisable to pass a unanimous resolution. This must also be notarized.

On the side of the controlling company, if it is also a stock corporation, a partnership limited by shares or an SE, the same applies as for the dependent company—i.e., an approval resolution is required, to be adopted by a three-quarters majority and notarized. If, however, it is a GmbH, a three-quarters majority is sufficient for approval. Notarization is not necessary in this case.

For the profit and loss transfer agreement to be effective, it must also be entered in the commercial register of the subsidiary.

Tax advantages

The tax advantages of a profit and loss transfer agreement arise primarily from the possibility of a tax Organschaft. This makes it possible for the dependent company’s profits and losses to be consolidated at the level of the controlling company.

For tax purposes, the dependent company’s profits and losses are treated as income of the controlling company. This can lead to more efficient use of tax loss carryforwards and allowances. Through the Organschaft, the dependent company’s profits can be taken into account when determining the controlling company’s corporate income tax. This can reduce the effective tax burden. It is advisable to set a minimum contract term of five years. In a recent decision (BFH ruling of 2022-11-02, I R 29/19), the Federal Fiscal Court pointed out that the profit and loss transfer agreement must be implemented throughout its entire term.

It is important to note that the tax advantages of a profit and loss transfer agreement are not without risks. Meeting the requirements for a tax Organschaft is crucial, and there are legal and tax aspects that must be carefully considered.

Profit and loss transfer agreements in an M&A context

In an M&A context, clear provisions on terminating profit and loss transfer agreements play a key role, since both the seller and the buyer have an interest in legally secure termination of the agreement, at the latest at the time the shares are transferred. The buyer wants to retain future profits, while the seller no longer wants to be obliged to compensate losses. When drafting the purchase agreement, the following points in particular should therefore be taken into account:

• Legally secure timing for terminating the profit and loss transfer agreement
• How can the profit and loss transfer agreement be terminated (company sale as a contractually defined extraordinary ground for termination) or rescinded?
• What provisions are required with regard to the income tax Organschaft?
• What provisions are required regarding profit transfer claims/loss compensation claims up to the effective date (e.g., impact on the purchase price)?
• Indemnification from any loss compensation claims

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